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A Good Fed Move

By Floyd Norris March 7, 2008 4:22 pmMarch 7, 2008 4:22 pm

Notes on wild markets, and worried economists:

The jobs report today was a bad one, but there is good news in the market reaction this afternoon. Even when stocks were sliding, the financials did better than other shares. And the Fannie Mae spread that I wrote about today is down a bit. These are signs that panic is not spreading, and that is good.

It was absurd for people to worry about Fannie Mae and Freddie Mac meeting their obligations — yes, Virginia, I believe in the implied guarantee. But the fact that traders seemed to be concerned was a cry for help from the markets, and the Federal Reserve responded with its moves to add liquidity today. The idea of the central bank as lender of last resort goes back at least to Walter Bagehot, and while it is easy to forget about that amid all the talk about the Fed setting interest rates, it is clearly required right now.

The speech Ben Bernanke gave earlier this week raised the idea that banks should voluntarily reduce the principle of mortgage loans as a way to keep borrowers afloat — and to keep them from just walking away from mortgages on which they owe more than the homes are worth.

There is what looks to me to be an interesting response to that in today’s Wall Street Journal by Martin Feldstein, the Harvard economist and former Reagan advisor. He writes:

“Proposals to force creditors to accept write-downs of interest or principal violate their contractual rights, reducing the future availability of mortgage credit and raising the relative interest rate on future mortgages. Reviving the Depression-era Home Owners’ Loan Corporation would have the government use taxpayer money to pay off existing loans and become the largest mortgage lender in the country. This would require an enormous federal bureaucracy of appraisers and loan agents.”

That last idea, about reviving the H.O.L.C., was floated by Alan Blinder, the Princeton economist and former vice chairman of the Fed, in The Times last Sunday.

Mr. Feldstein’s solution is for a different kind of government bailout. He would have the government make loans to struggling homeowners, who would use the money to reduce what they owe on existing mortgages. The interest rate would be very low — basically what the government pays to borrow short-term money.

The catch would be that the government loan would be binding on borrowers whether or not they walked away from the mortgage. So the homeowner would have less incentive to do that.

It is a fairly simple idea, albeit one that imposes a difficult choice for troubled homeowners: Take the money, and risk having to file for bankruptcy if you cannot pay the loan, or keep a high cost mortgage that you can walk away from if the price of the home continues to fall.

Many of the other suggestions, including Mr. Bernanke’s, could be frustrated by the legal complexities of who, if anyone, can modify a loan that has been put into a pool of loans and securitized. A modification that would clearly be a good idea for a bank that owned the entire loan might be a bad idea for holders of one or more tranches of securities.

Perhaps Congress could pass a law giving those who are servicing loans the right to modify them, even if owners of some classes of securities would be hurt.

The idea that home prices could fall, and keep doing so, was never contemplated when those contracts were drawn up. If the securitization market for mortgages ever revives, it is something that will be considered, and I assume agents will have greater power to modify loans. Letting them have that power now might help.

first of all giving people loans at below market rates is a handout. I bought a home in August. I could have qualified for a mortgage for five or six times the mortgage I obtained. I guess that was a mistake because I could have taken out a higher mortgage and then had it modified in my favor.
“The idea that home prices could fall, and keep doing so, was never contemplated when those contracts were drawn up.” Not so. Plenty of people were saying that real estate prices were unsustainable. Maybe those people didn’t work for Countrywide or Citigroup but they were out there.

It won’t help because nearly everyone who purchased a home in the bubble areas (SoCal, SoFla, AZ) over the last 4 years can barely afford the interest only teaser rate that they have (that’s going to reset, BTW). So when they lost 20% on their 500K house, they have to pay 9.9% on a 400K loan and 4% on a 100K loan, when they were paying 2.5% on a 500K loan. The only way to save them is to let them write off the loss of equity AND give them a loan at interbank (4% or so) rates.

Almost all the bailout plans are aimed, at the end of the day, at getting money to the banks. Dean Baker at CEPR points out that they will implicitly saddle struggling homeowners with loans greater than the value of their homes. His idea — the best I’ve seen — would be for bkrpcy judges to foreclose, subject to the right of the tenant in place to rent from the bank at market rent. Banks takes the hit for a loan it never should have made, while vacant derelict home is avoided. Lots of practical difficulties, including necessary mod in bcy law, but all others are full of practical difficulties as well.

In sum, the experts agree on one thing — all solutions to the current situation suggested thus far violate either a legal right or a moral principle (e.g., holding individuals accountable for their actions, avoid creating yet another government bureaucracy or subsidy, etc.).

But consider what Bill Richardson did in New Mexico. In 2003 he pushed through a law providing stronger protection for mortgage borrowers. This was a law — the written articulation of a social value — to limit the potential negative impact of certain market behaviors. Rather than create more government he added a rule to the game of competition. The result put New Mexico near the bottom of states damaged by the subprime mess. His action actually benefited home owners AND lenders since his state contributed proportionally less to the large write-offs. It was a win-win for the industry and for the consumer. But how many “players” (you know, the ones itching for that 9 figure payout or the bigger house in the Hamptons or France or wherever) will fight against such limitations?

When will the next shoe drop? By recent comments on MSNCNBC’s website, that would be the Alt-A mortgages. So if there is a significant increase in defaults beyond the sub-prime mortgages, what can be done to prevent the financial system from falling over the proverbial abyss. Much has been discussed with respect to the “moral hazard” of bailouts at the top for the banks or at the bottom of the financial food chain for the individual borrowers.

I would hazard to guess that the current prescriptions for the “cure” of the financial-credit crisis illness will prove to be largely ineffective. There will be massive coming foreclosures of homes and a number of failed [bankrupt] financial institutions and a far greater number of them facing insolvency.

A possible Rx [prescription] for this possible financial epidemic would be three fold. One the bankruptcy provisions that do not allow judges to reform individual homeowners mortgages must be changed. This provision is in my opinion constitutionally suspect anyway. [The differing treatment of investors [speculators] from owner occupied borrowers.] Second, the banks that are insolvent should be allowed to fail, taken over by the government and then sold for a profit after this crisis is over. Thirdly, the whole mortgage financing scheme for residential purchases should be re-examined. Homes are not productive, income producing assets. They are among the basic necessities of life, along with clothing and food supplies. A blueprint for the financing on a long term basis these not productive assets must be developed. Perhaps, direct long-term tax exempt financial instruments issued by a national-state-local governmental financing authority maybe the best answer. By making the income from these long-term financial instruments exempt from all taxation with explicit guarantees of the full faith and credit of the issuers, low fixed rates would be achieved. The mortgage deduction for homeowners would be eliminated for the interest paid on these mortgages. The loss of the individual tax advantages of the borrower would be more than offset by the lower monthly mortgage principal and interest payments.

Two supplemental remedies which need consideration are long term job growth in high wage jobs [manufacturing] and stabilization of the value of the dollar [increasing the value of the dollar]. National defense priorities legislation would be a starting point for rebuilding the manufacturing base of the country. And a tax system which would provide adequate revenue to finance the needs of the country would stabilize the value of the dollar. The twin deficits, trade and financial, must be eliminated by a common sense approach to taxation for this country to survive and prosper.

The inventory of foreclosed homes is going to keep going up. Many more will mail in their keys and walk away. The lenders will commit the suicide of making the inventory of unsold homes grow. The downward spiral will continue. The price for this Katrina response will be a prolonged recession.
There must be an option to foreclosure. An agency must be created to let the lenders “lay off” a mortgage rather than foreclose.
A foreclosure of a property that is fifty thousand under water will only cost more if expenses are incurred and the market continues down.
At auction, a property that is fifty thousand dollars down has a future value that will be indicated by the level at which the borrower will accept a refinancing.
A lender will probably receive more at auction based on the perceived future value of the property.
Foreclosure will be subject to continued maintenance, and selling expense and the threat of lower value caused by an ever increasing inventory of unsold homes.
The Home Owner’s Loan corporation accepted about half of the applications made. The HOLC managed to save a million homes. The HOLC functioned from June,1933 until June, 1936. The last loans were closed out in the late ’50s.
The Home Owner’s Loan Corp. paid all of its bills and returned a small profit to the treasury. The HOLC paid cash and replenished the capital tied up in non performing loans. The frozen capital in unsold inventory is part of the credit squeeze.

“difficult choice for troubled homeowners: Take the money, and risk having to file for bankruptcy if you cannot pay the loan, or keep a high cost mortgage that you can walk away from if the price of the home continues to fall.”

Not necessarily so difficult. If the loan in place was anything other than an owner-occupied, purchase money loan, it is a recourse loan, which is to say that the bank can come after the debtor for the deficiency even after sale of the house — except in bankruptcy. So if you’ve refinanced, there is no choice, take the cheaper money as you’d have to file bk to get out of the debt anyway.

All those purists that are advocating a non-interventionist policy by the government and the Fed MUST realize that this is not an ordinary intervention and failure to act will have severe consequences in the US for a generation to come.

At risk are the living standards of the rich and the poor alike; and Latin-Americanization of the US and the demise of the so called “Middle Class”.

To Mr. Hassan Azarm
We are probably going to have “severe consequences in the US for a generation to come” no matter what solution is sought.
With quickly dropping real estate prices, a dollar which is falling just as fast and the American consumer deep in debt, real solutions are likely to be elusive.
While there probably should be more oversight of banking, an industry which seems to have adopted the single word “greed” as its mission statement during the last decade and a half, why is American education missing in action?
Why don’t many Americans understand compound interest and teaser rates–it is not difficult math? Do high schools even teach what we called “consumer ed” anymore? Maybe the big banks lobbied to have it removed from the curriculum, perhaps that’s why people don’t seem to understand that payments to credit card companies first go to retire the lowest interest rate, the teaser rate, first, not in the order the charges were made, leaving the high interest rates charged on such things like cas advances to rach up while the consumer can do nothing to curtail these finance charges.
Where are those who fancy themselves as educators? It shouldn’t take an MBA to manage a household’s finances should it?

While I try not to double post on any article, I wanted to note that Illinois Attorney General, Lisa Madigan, announced yesterday that she was issuing new subpoenas to Countrywide and Wells Fargo of Illinois on the heels of an investigative report by the Chicago Reporter.
According to the report “The study also found marked disparities in loan pricing between white and non-white borrowers, with African American borrowers three times as likely as white borrowers to receive a high-cost home loan and Latino borrowers twice as likely.”
Again, why does American education seem to be missing in action? What is the reason for this?

Yes, I agree that the US is going to face major headwind regardless of what solutions are finally implemented to deal with the Housing crisis at hand. However, we could face a potentially violent raction from a public that feels that they have been robbed of their wealth/future and see no sense of fairness in the system. In a society driven by extreme materialism and greed, the “severe consequences” would be magnified/multiplied by many folds, as we have witnessed it in Brazil/Argentina/Chile etc. of a few decades ago.

As far as education is concerned, you have put your finger on the ultimate challenge facing the US as a Nation. Most importantly, the rising cost of education has put the US in a disadvantage vis a vis other countries with “high quality publically funded” education systems. We are back to an elitist medival system that only the nobility (the rich) and the clergy (defacto spiritual figures) were educated and the masses were left far behind.

That is why a “responsible government with political will and social conscience would regulate the financial system and other institutions of public concern/interest to protect the innocent, the uninformed and the undereducated”.

Dr. Bubble, a.k.a. Alan Greenspan is well educated, despite dropping out of his Ph.D. program at Columbia University and amusing himself playing Saxophone. He and the entire well schooled entourage at the Fed, SEC, Congress and above all the successive Administrations since Ronlad Reagan; have gradually dismanteled the regulatory system in the country and have allowed a bunch of fee hungry felons take the Nation to the cleaners.

The “expert” cast members in the private sector as well as the government were all aware of the deadly consequences of these practices and they sadly “elected” to close their eyes and ears and threw the people desparately wanting to realize their American Dream to the wolves….

Let’s say we started with the $200,000 30-year at 6.00%, with a P&I of $1,199.10. Two years later we strip that into a $155,949.18 28-year loan at 6.00% ($959.28) and a $38,987.29 15-year loan at 1.6% ($243.77) giving us a new payment of $1,203.05! Cool! Economic stimulus! That $3.95 a month that would have been blown at Starbucks going to debt reduction! Just what we need in a recession!

Plus, we don’t need any government agency to handle it! Servicers can do all the work, draw up the docs, execute them all, apply all the funds, modify the payments on the old loans, and then get that $243.77 check every month, which they can just mail to Washington! We don’t need no steenkin’ bureaucracy on the other side! The receptionist at the Treasury can probably handle it all in her spare time! Sure, she doesn’t have any idea how much she’s owed for what loan and when any given loan matures and what to do if the payment doesn’t show up, but she doesn’t have to! Countrywide will keep track of it all for her! There’s nothing wrong with their bookkeeping ever! And you know they’ll do all that for free, because they’re good citizens! So there’s no servicing fee eating into that 1.6% the government earns on these loans! No upfront fees to the borrower that offset the interest savings, because loan originators, like loan servicers, also work for nothing! Free lunch!

[Downturn Tests the Fed’s Ability to Avert a Crisis
By VIKAS BAJAJ
[Lenders and businesses are becoming more cautious about whom they lend to and hire, slowing the economy more.]

[American banks have been quick to recognize losses, and policy makers have moved to contain the damage and protect the broader economy. In Japan, many lenders did not write off bad loans and the central bank was much slower to respond. The 1990s is broadly seen as a “lost decade” for that country.]
The US has already suffered about as much damage as Japan did, and it is plain and accepted here that far more damage is threatened. No wonder US banks have been “quick”, but policy makers have done little more so far than Japan’s token efforts. When trillions are lost, trillions are needed to replace them.
Writing off bad loans does not of itself solve liquidity problems. Nor does a nominal bank rate of zero, as Japan does demonstrate.
There are more ways than one of being “aggressive”.

James, no5, does not spell out what he means by “increasing the value of the dollar”, but I guess that he means for US residents, not European ones. That has become a popular song, and it suit’s the rich. A dollar priced high in other currencies is the cause of the destruction of the manufacturing base. It moves buying power from the manufacturers and their employees to the owners of money. It makes holidays abroad cheaper, and also pushes down wages. Is that a good bargain? Lower exchange rates is what Keynes was on about, and Roosevelt did.

If anyone is going to get bailed out, it’s going to be the bond insurers, not Mr. and Mrs. Minority Mortgage Holder. “Sub-prime” has become just another racial code word and judging by the comments on this and other blogs the real “victims” are the persons who dutifully keep paying their mortgages even as their home values fall, while the minorities, as usual, get bailed out by the government.
I propose, however, what may be the only fair solution: mortgage principals should be able to be reset downward when home values drop and that goes for all mortgages for all owners. That way lenders won’t be so quick to pull the trigger if they, too, have to share the pain when prices fall.
The whole sub-prime mess, serious as it is is a diversion from the greater, huge really, under reported dangers lurking for not only for the U.S., but for the global financial markets. Nearly every day lately at least one hedge fund says it can’t meet its margin calls. These calls are coming with increasing frequency. Daddy Bush’s Carlyle Group, as a front for Arab money, has one of these funds in default. Many more margin calls are on the way. The derivatives probably total between $400 and $500 trillion. The total asset base of the G-7 countries is between $25-30 trillion. There is, in short, no way to cover all these obligations. The Fed is going to have to pump in $200 billion a day from now to the end of the year to prop up this corrupt and lawless system….but, never mind, I know, it’s all the uneducated “sub-prime” borrowers fault for not reading the fine print on their mortgages.

If innate intelligence is distributed among each generation roughly the same and each generation is exposed to the same content in high school and college (debatable but I believe mostly true) then why do we have such poor decision making? Throw in the fact that the percentage graduating from high school and the percentage entering college have both steadily risen and it is perplexing. Yet I agree that some sizable percentage of home buyers (and almost all buyers of mortgage investments) should have known better.

In terms of education, consider this comparison. Post-WWII the universities where overflowing with students (mostly males). Their lives delayed by the war, they knew why they were in college and what they wanted from the experience. The same cannot be said for the many young people who have gone off to college over the past 20 years. Broad generalizations are risky and unfair but l believe many of our young people have been directly and indirectly encouraged to delay engaging in some educating and maturing experiences (e.g., getting a job in high school that forces them to interact with adults, helping with the family business, exploring an interest that could lead to a career — excluding sports). The hallmarks of modern university life for administrators and faculty are classes with students unclear as to why they are there and calls from a parent explaining a student’s absence, questioning a grade, or arguing why their son or daughter should not be dismissed for poor academic performance or for misbehaving in the dorms. How often do you think parents of those post-WWII students picked up the phone? This is not a cry for the “good old days” but rather an observation that broader social factors are at work.

Finally, having researched and written about fraud, and served as an expert witness in the prosecution of pyramid schemes, I have seen some well-educated people buy into schemes that in the full light of day were clearly scams to benefit a few. I would bet dollars to doughnuts that I could devise a scheme that could take money from ten of thousands (perhaps hundreds of thousands) of people (check out the popularity of lotteries and gambling).

Why should the market in mortgage securities EVER recover? Is it not painfully clear that without transparency and oversight, the people playing with these securities can’t be trusted? I defy anyone to convincingly argue that public interest is served when traders take ill-advised risks with enormous amounts of public debt and are then bailed out when their bets go bad.

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